January 11, 2012

CDOs: Designed for Fees, Not to Fail

An important new study on collateralized debt obligations (CDOs) finds that the assets used to make CDOs just prior to the financial crisis consistently performed much worse than comparable non-CDO assets. The authors suggest that banks used CDOs to transfer low quality assets to CDO investors as part of a plan to unload financial "lemons."

A Bloomberg story on the paper notes that it supports the narrative that prior to the financial crisis bank issued CDOs that were "designed to fail" and stuffed with toxic mortgage-related risk. Dealbreaker's Matt Levine also argues that, in any case, such activities may reflect well on banks' risk management to the extent CDOs were intended to transfer mispriced assets to investors.

However, while the paper does indeed bolster the case that CDOs were used to transfer risk, it is actually more likely that structuring and issuing CDOs was motivated primarily to generate fees for underwriters (and ratings firms). This is because underwriters continued to create CDOs even when outside investors stopped buying them.

As noted by the Financial Crisis Inquiry Commission report (p. 188), despite a lack of outside investor interest in buying CDOs, by 2006

The CDO machine had become self-fueling. Senior executives—particularly at three of the leading promoters of CDOs, Citigroup, Merrill Lynch, and UBS— apparently did not accept or perhaps even understand the risks inherent in the products they were creating. More and more, the senior tranches were retained by the arranging securities firms, the mezzanine tranches were bought by other CDOs...

Importantly, the "other CDOs" were also created by CDO issuers to purchase mortgage-related securities that outside investors did not want to buy. As the IMF explained in a 2008 report (p. 59):

These CDOs-squared and structured-finance CDOs were created almost solely to resecuritize MBS and CDO mezzanine tranches, for which there was not sufficient demand from investors. Therefore their value added in transferring risk is questionable.

While the "designed to fail" motivation may explain some CDOs, the fee-generation explanation seems superior and indeed underlies perhaps most important result of pre-crisis CDOs: they did not transfer risk but rather caused billions of dollars in write-downs at the financial institutions that created them.